The Effect of Foreign Bank Entry and Ownership Structure on the Philippine Domestic Banking Market -...

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Journal of Banking & Finance 27 (2003) 2323–2345

The effect of foreign entry andownership structure on the Philippine

domestic banking market q

Angelo A. Unite a, Michael J. Sullivan b,*

a Economics Department, De La Salle University, Manila 1004, Philippinesb Department of Finance, University of Nevada––Las Vegas, 4505 Maryland Parkway,

Las Vegas, NV 89154-6008, USA

Received 19 April 2001; accepted 20 May 2002

Abstract

We examine the response of domestic Philippine banks to the relaxation of foreign entry reg-

ulations that occurred in the Philippines. We find evidence that foreign bank entry is associated

with a reduction in interest rate spreads and bank profits, but only for those domestic banks

that are affiliated to a family business group. Foreign entry corresponds more generally with

improvements in operating efficiencies, but a deterioration of loan portfolios. Overall, we con-

clude that foreign competition compels domestic banks to be more efficient, to focus operations

due to increased risk, and to become less dependent on relationship-based banking practices.

� 2002 Elsevier B.V. All rights reserved.

JEL classification: E44; G21; G32

Keywords: Foreign entry; Domestic banking; Ownership structure

1. Introduction

In recent years the Philippines has embarked on a number of economic policy re-forms aimed at liberalizing and internationalizing its domestic financial markets. In

qThis paper is based on a team research project of the De La Salle University Angelo King Institute for

Economic and Business Studies funded by the Philippine APEC Study Center Network (PASCN) and

titled, ‘‘Impacts, Risks and Opportunities of Financial Liberalization and Integration: A Micro–Macro

Analysis’’.* Corresponding author. Tel.: +1-702-895-4669; fax: +1-702-895-4650.

E-mail address: [email protected] (M.J. Sullivan).

0378-4266/$ - see front matter � 2002 Elsevier B.V. All rights reserved.

doi:10.1016/S0378-4266(02)00330-8

mail to: [email protected]

2324 A.A. Unite, M.J. Sullivan / Journal of Banking & Finance 27 (2003) 2323–2345

general, these reforms involve the relaxation or removal of barriers to international

investments and the easing of barriers to international capital flows. An important

subset of these reforms is centered on liberalizing restrictions on the involvement

of foreign interests in the domestic banking market. This liberalization is of two gen-

eral forms; regulations that allow the entry of foreign-controlled banks, and regula-tions that provide incentives for foreign ownership of the common stock of domestic

banks. The most consequential of these regulations is Republic Act no. 7721, which

was passed in May 1994, and allows the entry of additional foreign banks to operate

in the Philippines and allows a foreign bank to acquire up to a 60% interest in an

existing domestic bank. 1 The intent of this particular act was to change the compet-

itive landscape of the Philippine banking sector through an influx of foreign compe-

tition and was based on the premise that greater foreign competition will prompt

sounder banking practices. Furthermore, there were additional incentives aimed atencouraging foreign ownership of the common stock of Philippine companies, in-

cluding that of banks, that occurred over the years 1992–1998 as the Ramos admin-

istration focused on economic liberalization.

It has been conjectured that increases in foreign bank entry increase competition

and, therefore, act to compel domestic banks to operate more efficiently (Terrel,

1986; Bhattacharaya, 1993; McFadden, 1994; Levine, 1996; Kroszner, 1998; Claes-

sens and Jansen, 2000; Claessens et al., 2001). For example, Kroszner (1998) argues

that greater foreign bank penetration in an emerging market economy improvesbanking practices, since foreign banks tend to be less politically connected and are

less likely to exert self-promotional influence upon regulatory authorities. Levine

(1996) summarizes purported benefits of allowing foreign bank entry to be (1) the

improvement of quality and availability of financial services and the adoption of

modern banking skills and technology, (2) stimulating development of the bank su-

pervisory and legal framework, and (3) the enhancement of a country’s access to in-

ternational capital. Specifically, it is asserted that greater foreign penetration causes

domestic bank interest rate spreads to narrow and profitability to decline as newcompetitors reduce the market price of funds in an attempt to build market share.

However, direct empirical evidence demonstrating that foreign bank penetration af-

fects interest rate spreads and bank efficiency is limited. Recent liberalization of for-

eign bank entry in the Philippines provides us the unique opportunity to undertake a

comprehensive study of these issues within a natural laboratory setting due to four

distinct advantages. First, foreign bank entry is confined to a single year where a sig-

1 Republic Act no. 7721 (RA7721), titled ‘‘An act liberalizing the entry and scope of operations of

foreign banks in the Philippines’’, was passed into law on May 18, 1994. Bangko Sentral Circular no. 21

dated October 14, 1994 provided the implementing rules and regulations. RA7721 allowed the entry of

foreign banks through one of the following methods. First, 10 new foreign banks were allowed entry into

the Philippines with each given full banking authority and the rights for up to six branches. Second, an

unrestricted number of foreign banks were allowed up to a 60% ownership stake in any new Philippine

banking subsidiary. Third, an unrestricted number of foreign banks were allowed to acquire, purchase, or

own up to a 60% ownership stake of an existing bank. This Act amended the General Banking Act of 1948,

which had previously been amended by Republic Act no. 337. Republic Act no. 337 had limited the

number of foreign banks operating in the Philippines to four.

A.A. Unite, M.J. Sullivan / Journal of Banking & Finance 27 (2003) 2323–2345 2325

nificant number of foreign banks were granted rights to establish operations. This

allows us to better isolate the effects of foreign entry. Second, confounding effects,

such as restrictions on capital accounts, are largely absent in the Philippines, as gen-

eral economic liberalization took place prior to the liberalization of foreign bank

entry. Third, the study of a single country allows a more direct test of the effect offoreign competition within a uniform environment. Finally, unlike many developing

countries the Philippine government plays only a minimal role in the ownership of

banks. A large degree of state ownership may create a cartel-like environment that

could distort results (Cetorelli and Gambera, 2001).

Besides considering the impact of foreign bank entry, we also examine how

changes in the level of foreign ownership affect domestic banks. Foreign ownership

of domestic bank common stock may help alleviate two perceived problems in the

Philippine banking market, namely a lack of effective monitoring and the preponder-ance of relational banking practices (Li, 2000). These problems occur in the Philip-

pines, and commonly in other emerging market economies, due to a corporate

governance system that is typified by high ownership concentration. In the Philip-

pine case this ownership concentration is centered around family corporate groups

that control a large portion of corporate assets, and likewise, have significant own-

ership in the nation’s large commercial banks. 2 For example, we find that 10 of the

16 large domestic Philippine commercial banks are subject to significant group own-

ership. Additionally, when affiliation is more broadly defined to encompass relatedparties, including group companies, affiliated companies, and managerial insiders,

we find all large commercial banks are effectively controlled by these related parties.

As a consequence, bank managers are often related or appointed by the dominant

ownership group, and therefore, owe some allegiance for their position (see Rivera

and Koike, 1995). The resulting system of relationship-based banking may hinder

economic growth, since these banks may not fulfil an intermediary role by acting

as effective corporate monitors (Li, 2000). 3 Consequently, a decline of group influ-

ence may act to diminish the presence of relationship-based banking, and in turn,may enable large commercial banks to better monitor corporate activities.

Within this framework, we investigate how foreign bank entry and changes in for-

eign ownership affect the operation and structure of domestic banks in the Philip-

pines. We undertake this analysis using bank-level accounting data and general

macroeconomic data for the time period covering 1990–1998. We find evidence that

2 We define corporate governance from an agency perspective similar to Shleifer and Vishny (1997).

Corporate governance is viewed as the relationship between corporate stakeholders and managers and how

these participants determine the direction and performance of the corporation. Corporate stakeholders

can include both holders of equity and debt, as well as employees and suppliers. In other words, corporate

governance focuses on who controls corporate assets and on the decision-making process regarding where

capital funds are allocated.3 For example, severe economic downturns occurred in Thailand, South Korea, and Indonesia in 1997,

at least in part, due to problems exacerbated by the ownership structure of banks and the relationship

between these banks and corporate groups (Krugman, 1998; Li, 2000). In addition, Philippine banks are

found to concentrate their lending to large, related corporations raising concerns about lending risk

(Hutchcroft, 1998).


an increase in foreign bank entry acts to reduce interest rate spreads and operating

expenses. This evidence supports our conjecture and the evidence of related studies

(Denizer, 1999; Claessens et al., 2001). However, the narrowing of interest rate

spreads are concentrated only in banks with higher levels of group-affiliate owner-

ship, while gains in efficiency are lower for domestic bank subject to rising foreignownership of their shares. We also uncover evidence that foreign entry brings about

an increase in loan loss provisions similar to findings of Barajas et al. (1999b), while

changes in the percentage of foreign ownership of domestic banks is inversely related

to the amount of income earned from non-traditional banking sources.

2. Related literature

There are only a handful of empirical studies that directly examine the impact of

liberalizing foreign bank entry on domestic banking markets. The most comprehen-

sive of these is by Claessens et al. (2001). Using bank level data for 80 developed and

developing countries over the 1988–1995 period they examine the impact that foreign

bank entry has on domestic bank net interest margins, profitability, non-interest in-

come, overhead expenses, and loan loss provisions. They find that an increase in for-

eign bank presence is associated with a reduction in profitability, non-interest

income, and overall operating expenses of domestic-owned banks. These resultsare interpreted as evidence that foreign bank entry improves the efficiency of na-

tional banking markets and provides positive welfare implications for a domestic

economy.

Studies investigating the effect of bank liberalization for particular countries in-

clude Terrel (1986), Bhattacharaya (1993), McFadden (1994), Clarke et al. (1999),

Denizer (1999), and Barajas et al. (1999a,b). Terrel (1986) studies aggregate account-

ing data for the banking markets of 14 developed countries and finds that countries

where foreign bank entry is allowed tend to have relatively lower gross interest mar-gins, lower before tax profits, and lower operating costs. In Bhattacharaya’s (1993)

investigation of the national banking markets of Pakistan, Turkey, and Korea he

discovers that entry by foreign banks increased the amount of foreign capital avail-

able to fund domestic projects. Through an examination of the Australian banking

sector McFadden (1994) uncovers evidence that foreign bank entry improves domes-

tic bank operations.

In a study of Argentine banks Clarke et al.’s (1999) data supports a contention

that greater foreign bank presence instills competition in some areas for domesticbanks. However, they believe this effect is somewhat mitigated since foreign banks

primarily specialize in areas that are not in direct competition with domestic banks.

In addition, their work looks primarily at indirect forms of foreign entry. Most of

the rise in foreign presence is derived from the foreign acquisition of troubled do-

mestic banks and an increase in the size of foreign banks. Denizer (1999) examines

the effect of foreign entry on Turkish banks finding that foreign entry reduced do-

mestic bank profitability and overhead expenses, and interprets this as evidence

that foreign entry increased efficiency. However, he surmises that the effect of for-


eign entry would have been greater if capital account had been opened earlier. Tur-

key allowed foreign entry starting in 1980, whereas capital accounts were not

opened until 1989.

Barajas et al. (1999b) investigate how the liberalization of foreign participation

affected the Colombian financial sector. They find some confirmation that liberaliza-tion reduced intermediation spreads and loan quality, but that liberalization in-

creased administration costs. However, when considering specific relationships

based on the number of foreign banks entering Colombia they find that intermedi-

ation spreads are not affected by entry. A problem is that it is difficult to evaluate

the effect of foreign bank entry using Colombian data for the following reasons.

First, the government owned a substantial portion (55%) of bank assets in 1991 when

liberalization began. A conversion of much of these assets to private banks through-

out the decade may have overwhelmed any effect attributed to foreign bank entry.Second, an increase in foreign bank participation apparently took years to occur

in any significant sense. While the percentage of domestic banks with foreign partic-

ipation was at 7.6% in 1991, it increased to only 9.7% by 1996 before accelerating to

31.4% in 1998.

These studies are subject to some limitations based on their structure and the

countries studied. First, studies investigating effects across countries are inherently

confronted with the problem of separating our effects associated with foreign bank

entry from effects attributed to contrasting economic and regulatory factors. Sec-ond, any effect derived from increased foreign penetration depends on whether

other financial reforms have taken place, such as, domestic financial deregulation,

strengthening the regulatory and supervisory framework, capital account liber-

alization, and privatization of bank assets (Claessens and Jansen, 2000). In the

aforementioned studies, these other financial reforms have taken place either simul-

taneously or subsequent to the deregulation of foreign penetration. Finally, in pre-

vious studies deregulation of foreign entry has occurred over long periods of time,

such that, it becomes more difficult to isolate associated effects.There is also a body of related research that highlights the importance of an effec-

tive banking regulatory system. Demirg€uuc�-Kunt and Detragiache (1998) have dem-

onstrated that countries with weak institutional environments, characterized by

ineffective legal enforcement, inefficient bureaucracies, and corruption, are faced

with greater prospects of instability in their banking sector in the time period imme-

diately following financial liberalization. LaPorta et al. (1998) investigate how cer-

tain legal and political features evolve and demonstrate that a country’s legal

system is determined primarily by its culture and history. Rajan and Zingales(2000) expand on this work and demonstrate a link between political considerations

and the institutional impediments to financial development. Overall, these studies re-

port that many countries do not develop efficient financial and legal systems, even

when it is generally agreed to be economically beneficial, because politicians fear a

redistribution of economic wealth and the loss of political control. However, Rajan

and Zingales (2000) believe globalization and technological change may be impor-

tant catalyst to overcome entrenched political interests and act as impetus for finan-

cial development.


3. Variable description and predicted relationships

As a means of investigating the effect of liberalization that has taken place in the

Philippines we analyze how greater foreign presence in the domestic banking sector

affects domestic bank operations. We define changes in foreign presence as addi-tional foreign bank entry and the change in ownership in domestic bank common

stock by foreign investors. Our sample includes all 16 domestic expanded commer-

cial banks (ECBs). We feel this sample forms an accurate representation of the Phil-

ippine domestic banking market. These 16 ECBs constitute on average roughly 70%

of the total assets of the entire commercial banking sector over the period of study,

1990–1998. The domestic ECBs in our set are all publicly traded on the Philippine

Stock Exchange (PSE) and all rank as one of the largest 1000 corporations in the

Philippines. Using these large ECBs also allows for a direct investigation of the effectof foreign bank entry since the markets served and the services provided by new for-

eign banks are comparable to those provided by the domestic ECBs. We believe the

smaller domestic banks not included in our analysis serve unique market segments

that are less likely affected by a change in foreign presence. We also consider other

factors that may affect bank operations, specifically measures of ownership structure,

bank-level variables, and general economic variables. The variables used in this

study are defined in Table 1.

One way to measure the change in foreign presence is to use a measure of foreignbank entry. For this variable we simply use the proportion of foreign banks to the

total number of large commercial banks (FOR#). With this variable we conjecture

that domestic banks react at the time of foreign bank entry in an effort to effectively

compete against these new market entrants. 4 We posit that foreign banks are moti-

vated by profit and market penetration and that domestic banks are forced to adopt

more efficient bank practices to maintain market share. Our other measure of foreign

presence is the percentage foreign ownership of domestic bank common stock. The

level of stock ownership by foreign investors may provide an indication of the open-ness and efficiency of that market. A rise in foreign ownership is thought to increase

outside monitoring activity and result in improvements in bank practices. To dem-

onstrate why this variable may be important, we find that foreign ownership of do-

mestic ECBs increased markedly from 8.69% of the total in 1992 to 14.81% in 1998.

To evaluate how changes in foreign presence affect bank operations we analyze the

effects of foreign entry on interest rate spreads, various measures of operating perfor-

mance, and risk. Similar to Terrel (1986), Barajas et al. (1999b), and Claessens et al.

(2001), we expect interest rate spreads will decline with greater foreign presence. Thisnarrowing of interest rate spreads may occur due to either a decrease in interest in-

come or an increase in interest expenses. Interest income may decline if loan rates are

4 Since this variable ignores the relative size of a bank, we also include a measure of foreign bank

penetration. The variable used to measure foreign bank penetration is the percentage of foreign bank

assets to total assets in the banking sector (FSZ). Use of this variable assumes that greater competitive

pressures result from a higher percentage of bank assets in foreign hands. Results of our tests using FSZ

are similar to those using FOR#, and therefore, are not reported.

Table 1

Description of dependent and independent variables

Variable Description

Dependent variables

Interest rate spreads (IRS) The difference between the ratio of interest income on loans to

total loans and the ratio of interest expense on total deposits to

total deposits

Operating performance

Accounting profitability (AP) Ratio of before-tax profits to total assets

Non-interest income (NII) Ratio of non-interest income to total assets

Operating expenses (OE) Ratio of total overhead expenses to total assets

Risk (RSK) Ratio of loan loss provisions or reserves to total assets

Independent variables

Foreign presence

Entry number (FOR#) The number of foreign banks as a percentage of all commercial

banks

Foreign ownership (FOR%) The percentage of foreign ownership

Ownership structure

Group affiliation (GRP) Affiliation to a domestic family corporate group, a dummy

variable equal to 1 if bank is affiliated and 0 otherwise

Ownership concentration (OWN) The percentage of insider, group, and related party ownership of

the top 20 owners

Group ownership (GROUP) The percentage of group ownership of the top 20 owners

Bank-level factors

Non-interest earning

assets (NIA)

Ratio of cash, non-interest earning deposits at other banks, and

other non-interest earning assets to total assets

Equity levels (EQ) Ratio of the book value of shareholder’s equity to total assets

Operating expenses (OE) Ratio of overhead expenses to total assets

Relative bank size (RSZ) The total assets of the bank as a percentage of all commercial

banks total assets

General economic factors

Inflation (INFL) Percentage change in the consumer price index

Capital scarcity (RINT) The real interest rate, calculated as the nominal interest rate on

short-term government securities minus the inflation rate

Reserve requirement (RR) Set by Bangko Sentral ng Pilipinas

Economic growth (GDP) The year-to-year percentage change in real gross domestic product


reduced as a bank attempts to fend off declines in the size of their loan portfolio.

Likewise, interest expenses may increase with rising deposit interest rates as the abil-

ity to attract new deposits becomes increasingly competitive. Interest rate spreads

(IRS) are defined as the average interest rate received by banks from their lending

activities less the average interest rate paid by banks to their depositors. 5

5 Claessens et al. (2001) and Demirg€uuc�-Kunt and Huizinga (1998) use net interest margin as a measure

of bank interest spread. They define net interest margin as the ratio of net interest income to total assets,

where net interest income equals total interest income less total interest expense. We instead chose to focus

on interest earned and paid through more traditional banking activities. For example, total interest income

includes income from investments and trading account securities, as well as interbank loan receivables and

deposits with other banks.


Hypothesis 1. An increase in foreign presence is expected to result in a decline in

interest rate spreads.

We measure a bank’s operating performance with three alternative measures; ac-

counting profitability, non-interest income, and operating expenses. Accountingprofitability consists of profits from all sources including interest rate spreads, as well

as, any profits derived from non-lending sources. Here we attempt to include the pos-

sibility that domestic banks may respond to increasing competition by seeking alter-

native sources of business to replace traditional bank business that was lost.

However, the realization of any non-lending profits may occur gradually. Therefore,

in the time period immediately following an increase in foreign bank presence, we

expect that accounting profits will decline.

Hypothesis 2. An increase in foreign presence is expected to result in a decrease in

accounting profits.

We also look separately at non-lending operations, because many commercial

banks in the Philippines engage in non-traditional banking activities, including in-

vestment banking and brokerage services. In addition, the importance of these activ-

ities may increase as competition erodes the market share of domestic banks in these

traditional banking areas. We use non-interest income as our proxy for a bank’s levelof non-lending activities.

Hypothesis 3. An increase in foreign presence is expected to result in an increase in

non-lending activities.

We analyze the effect a change in foreign presence has on operating expenses since

any associated improvements in managerial efficiency and organizational structure is

expected to result in a decline in operating expenses (Claessens et al., 2001). Simi-larly, Berger and Hannan (1998) discuss the possibility that with an increase in for-

eign bank entry, domestic bank managers may be forced to give up their sheltered

‘quiet life’ and exert greater focus on cost efficiency. In this study, operating ex-

penses are proxied by overhead expenses. These are expenses associated with a

bank’s lending and non-lending operations, including employee and managerial

compensation, fringe benefits, depreciation charges, overhead, and equipment-

related expenses.

Hypothesis 4. An increase in foreign presence is expected to result in a decrease in

operating expenses.

Claessens et al. (2001) argue that an increase in foreign bank presence may induce

domestic banks to take on relatively less creditworthy customers, thereby, increasing

bank risk. For example, domestic banks may give greater focus to retail lending as

foreign competition takes away safer wholesale business. Therefore, we expect that


the immediate impact of an increase in foreign presence is to increase the risk of do-

mestic banks as competition decreases profit margins, induces profit volatility, and

encourages the underwriting of riskier loans (see Shaffer, 1998 for a discussion of ad-

verse borrower selection). However, in the long-run, an opposing effect may occur if

competition encourages improved bank management, including underwriting proce-dures and greater bank disclosure. In this study we proxy bank risk by total loan loss

provisions. We assert that loan loss provisions are a reflection of the quality of a

bank’s loan portfolio.

Hypothesis 5. An increase in foreign presence is expected to increase bank risk in the

short term.

4. Data for the Philippine banking industry

We use accounting-based measures for interest rate spreads, operating perfor-

mance, and risk to circumvent problems associated with differences in market liquid-

ity of commercial banks in our sample, since trading activity in the Philippine stock

market is limited. Besides investigating how a change in foreign presence affects bank

operations, we also include variables to control for the possible influence of owner-ship structure, bank-level factors, and general economic factors as Demirg€uuc�-Kunt

and Huizinga (1998) find such variables as important. We gather specific account-

ing-based bank data from bank annual reports, the Philippine Stock Exchange Re-

search Department, and the Securities and Exchange Commission. Macroeconomic

data and data used to measure foreign bank entry are obtained from the Bangko

Sentral ng Pilipinas Statistical Center. Ownership data is obtained from the Philip-

pine Stock Exchange Research Department and the Securities and Exchange Com-

mission.Ownership structure variables include group affiliation and ownership concentra-

tion. 6 Group affiliation is a dichotomous variable describing whether a bank is con-

sidered affiliated to a domestic family corporate group. A domestic bank’s response

to a change in foreign presence may be affected by whether the bank is affiliated to a

group. Close ties to a corporate group may equate to close relational banking ties

that are largely immune to the effects of foreign bank entry. Or conversely, foreign

bank entry may have a more forceful effect on group-affiliated firms if this entry

helps reduce relational banking ties.

6 We also included a variable that measures the asset concentration of the three largest banks (3CON).

If foreign entry is important, this entry may decrease the concentration of bank assets. We find that asset

concentration increases from 31.98% in 1990 to 34.52% in 1994. Whereas in the post-liberalization period

asset concentration declines from 33.32% in 1995 to 28.53% in 1998. However, in subsequent tests we

found this variable did not have a significant effect and have therefore elected not to report related results.


Similar to Rajan and Zingales (2000), we use ownership concentration as our

proxy of political obstacles and the level of transparency. Because many emerging

economies are subject to high ownership concentration, we are interested in first de-

termining if this is the case with Philippine commercial banks, and if so, determining

the effect this ownership concentration has on bank operations. Ownership concen-tration is calculated as the percentage ownership of the five largest stockholders. We

surmise greater ownership concentration is an indication of the presence of political

obstacles and a resulting diminished transparency (see Kroszner, 1998). Therefore,

we expect relatively higher ownership concentration to lessen any effects from for-

eign bank entry.

To control for bank specific effects we include four bank-level variables; non-

interest earning assets, equity levels, operating expenses, and relative bank size. These

variables are included since they may be directly related to bank profitabilityand are consistent with previous research including the general model of Claessens

et al. (2001). The measure of non-interest earning assets controls for the level of

assets that do not directly generate interest income and is used to proxy for bank

efficiency. Although conventional wisdom predicts that higher equity levels should

be associated with lower earnings since higher equity levels correspond with lower

risk, findings for US banks demonstrate equity levels are positively related to earn-

ings (Berger, 1995). This positive relationship has been attributed to higher equity

levels being associated with lower expected costs of financial distress and a signalof better future performance. Operating expenses are used as an independent vari-

able in cases where we expect operating efficiency to be an important factor. The

relative size of the bank is included to capture any scale efficiency effects that

may be present. We hypothesize that a domestic bank’s response to foreign bank

entry may be related to the domestic bank’s size, which proxies for the extent of

its relationships and reputation. Having more concrete relationships and an en-

hanced reputation are expected to be positively correlated with the relative size

of the bank.We also include a set of general economic variables that may affect interest rate

spreads, operating performance, and bank risk. These variables include the yearly in-

flation rate, a measure of capital scarcity, reserve requirements, and economic

growth. The level of inflation controls for the expected direct relationship between

inflation with interest rate spreads and profits. Greater capital scarcity allows banks

to increase their spreads and profits but may have an adverse impact on loan losses.

The legal reserve requirement ratio is used because changes in this ratio will impact

on bank performance. A measure of general economic growth is included to controlfor any effect that general increases in economic activity may have on bank opera-

tions and profits.

Descriptive statistics for the entire Philippine commercial banking sector are pre-

sented in Table 2. These data highlight the dramatic jump in the number of foreign-

owned commercial banks starting in 1995, corresponding to regulation passed in

1994. The number of foreign-owned commercial banks increased from 4 in 1994

to 14 in 1995, or on a percentage basis went from 12.1% to 31.1% of the total number

Table 2

Descriptive statistics for Philippine commercial banks for 1990–1998a

Year Total Foreign Total assets Total deposits Average size INFL RINT GDP 3CON

Number % Foreign Domestic Total Foreign Domestic Total Foreign Domestic

1990 30 4 13.3 66,613 446,588 513,201 22,610 246,367 312,980 16,653.3 17,176.5 13.2 12.9 3.04 32.0

1991 31 4 12.9 64,196 504,605 568,801 22,983 299,962 364,158 16,049.0 18,689.1 18.5 5.4 )0.58 33.2

1992 32 4 12.5 63,705 581,191 644,896 26,043 352,107 415,812 15,926.3 20,756.8 8.6 9.4 0.34 33.1

1993 32 4 12.5 75,956 696,630 772,586 32,905 438,993 514,949 18,989.0 24,879.6 7.0 7.1 2.12 34.5

1994 33 4 12.1 86,522 889,731 976,253 42,073 574,502 661,024 21,630.5 30,680.4 8.3 5.5 4.39 34.1

1995 45 14 31.1 115,466 1,156,912 1,272,378 42,007 701,667 817,133 8,247.6 37,319.7 8.0 5.4 4.76 33.3

1996 46 13 28.3 202,977 1,515,700 1,718,677 51,680 831,017 1,033,994 15,613.6 45,930.3 9.1 4.3 5.85 31.4

1997 51 14 27.5 350,533 1,956,705 2,307,238 104,837 1,022,571 1,373,104 25,038.1 52,883.9 5.9 7.7 5.17 28.2

1998 50 13 26.0 387,734 1,886,107 2,273,841 134,244 1,060,473 1,448,207 29,825.7 50,975.9 9.7 7.7 )0.48 28.5

Includes all commercial banks except for three Specialized Government Banks (Al-Amanah Islamic Bank, Development Bank of the Philippines, and Land

Bank of the Philippines). Total assets and total deposit, and average size are in millions of pesos. Inflation (INFL), real interest rate (RINT), real gross

domestic product growth rate (GDP) are defined in Table 1, and bank asset concentration (3CON) is the asset concentration in the three largest banks,

measured as a percent of total bank assets.a Sources include the Bangko Sentral ng Pilipinas (1996, 1997a,b,c, 1998a,b, 1999).

A.A.Unite,

M.J.Sulliva

n/JournalofBanking&

Finance

27(2003)2323–2345

2333


of commercial banks. 7 Similarly, a rise in the amount of total assets and liabilities

began in 1995, but instead of an immediate jump the increase has been gradual. For

example, the average size of a foreign-owned commercial bank declined from

PhP21,630.5 million in 1994 to PhP8,247.6 million in 1995. However by 1998 the

average size of foreign commercial banks surpassed the 1994 level reachingPhP29,825.7 million. In addition, the average size of domestic commercial banks

appears to have increased in reaction to entry of foreign commercial banks. While the

average size of domestic commercial banks increased steadily from 1990 to 1993

from PhP17,176.5 million to PhP24,879.6 million, this trend accelerated in 1994, per-

haps due to anticipation of the regulation liberalizing foreign bank entry. By 1998

the average size of domestic commercial banks had increased to PhP50,975.9 million.

Our statistics vary from the summary statistics reported by Claessens et al. (2001)

and Cetorelli and Gambera (2001) for the Philippines. For example, Claessens et al.(2001), using data from BankScope for the years 1988–1995, gathered a sample of 17

banks in which they found that 46% were foreign having 57% of bank assets. In con-

trast, based on a sample that includes all domestic commercial banks and all foreign

banks, we find for the year 1995 that 31% of banks are foreign having 9.1% of bank

assets. Over the period 1990–1998 we find that on average foreign banks make up

21.2% of all banks and possess 12.8% of bank assets. In addition, Claessens et al.

(2001) and Cetorelli and Gambera (2001) report that the three largest banks have

a 40% market share of total assets, while we find that the market share of the threelargest banks averages 32.0%. These differences in summary statistics are probably

due to using different sources for data. Where these previous studies relied on a lim-

ited number of banks reported by BankScope, we collected data on all Philippine

commercial banks and we cross-check our data through multiple sources.

Table 3 presents statistics for interest rate spreads, accounting profits, non-inter-

est income, operating expenses, risk, and relative size for the 16 domestic ECBs in

operation during the years 1990–1998. Interest rate spreads are shown to vary widely

7 Prior to the passage of RA no. 7721 in May 1994, the four foreign banks that operated a branch or

branches in the Philippines were the Bank of America, Citibank, Standard Chartered Bank, and The Hong

Kong and Shanghai Banking Corporation Limited. After the passage of RA no. 7721, ten new foreign

commercial banks began operations in the Philippines in 1995 using the first entry mode, which was the

establishment of branches with full banking authority. These banks, including home country and year that

operations began, are as follows. ANZ Banking Group Ltd. from Australia started operations in 1995,

Bangkok Bank Public Co. Ltd. from Thailand in 1995, Development Bank of Singapore from Singapore

in 1995, Deutsche Bank AG from Germany in 1995, ING Bank from the Netherlands in 1996,

International Commercial Bank of China from Taiwan in 1995, Korea Exchange Bank from South Korea

in 1995, The Bank of Tokyo-Mitsubishi Ltd. from Japan in 1996, The Chase Manhattan Bank from the

USA in 1995, and The Fuji Bank Ltd. from Japan in 1997. However, in 1998, Development Bank of

Singapore (DBS) changed to the third mode of entry, acquiring an existing bank. DBS merged with a

domestic commercial bank called the Bank of Southeast Asia, to form what is now called DBS Bank

Philippines, Inc. which is classified as a subsidiary of a foreign bank. Four foreign banks began operations

in the Philippines using the second entry mode between 1995 and 1998. These are Banco Santander

Philippines, Inc. which is majority owned by Banco Santander, S.A. from Spain and which started

operations in 1996, Chinatrust (Phils) Commercial Bank Corporation in 1996, Dao Heng Bank, Inc. in

1996, and Maybank in 1998.

Table 3

Descriptive statistics on selected variables for 16 publicly traded domestic ECBs for 1990–1998a

1990 1991 1992 1993 1994 1995 1996 1997 1998 Average

Interest rate spreads ðIRSÞAverage 7.34 9.21 8.06 6.44 6.85 5.60 5.59 6.17 6.87 6.90

Standard

deviation

5.51 8.40 4.52 3.09 1.70 1.76 1.86 1.75 2.34 1.17

Minimum 1.35 2.27 4.06 3.63 4.34 2.48 2.43 2.56 1.88 5.59

Maximum 22.19 39.16 23.10 17.26 10.29 9.92 9.46 8.89 9.82 9.21

Accounting profit ðAPÞAverage 2.87 2.70 2.65 2.33 2.32 2.24 2.44 1.97 1.17 2.30

Standard

deviation

0.94 1.06 0.90 0.66 0.64 0.43 0.48 0.64 1.68 0.50

Minimum 1.35 0.39 0.48 0.83 1.38 1.42 1.86 0.67 )4.09 1.17

Maximum 4.77 4.60 4.13 3.26 3.98 3.02 3.52 3.05 3.41 2.87

Non-interest income (NII)

Average 3.83 2.70 3.56 2.96 2.44 2.81 2.24 2.08 2.23 2.76

Standard

deviation

0.98 0.86 1.91 0.56 0.65 2.60 1.03 0.79 0.64 0.61

Minimum 2.35 0.78 2.18 2.18 1.65 1.63 0.66 0.99 1.49 2.08

Maximum 6.28 4.37 10.29 3.78 4.43 12.42 4.49 3.92 3.62 3.83

Operating expenses ðOEÞAverage 3.95 4.13 4.32 4.20 4.02 3.70 3.44 3.19 3.66 3.85

Standard

deviation

0.70 0.60 0.99 0.83 0.80 0.70 0.53 0.52 0.60 0.38

Minimum 2.98 3.08 3.05 2.99 3.04 2.83 2.60 2.44 2.62 3.19

Maximum 5.25 5.81 6.66 6.10 5.97 5.37 4.51 4.26 4.75 4.32

Loan losses ðRSKÞAverage 0.60 0.26 0.25 0.18 0.16 0.82 0.25 0.80 1.43 0.53

Standard

deviation

0.40 0.24 0.22 0.17 0.12 2.22 0.20 0.45 1.03 0.43

Minimum 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.08 0.01 0.16

Maximum 1.30 0.73 0.67 0.51 0.37 9.11 0.84 1.50 4.43 1.43

Relative size ðRSZÞMedian 4.46 4.68 4.57 4.74 4.74 4.80 4.54 4.28 4.21 4.56

Standard

deviation

2.69 2.68 2.55 2.52 2.83 2.58 2.80 2.80 2.48 4.57

Minimum 0.43 0.46 0.52 0.59 0.63 0.64 0.59 0.53 0.52 4.21

Maximum 14.31 16.49 15.14 17.05 15.18 13.79 13.03 11.84 12.77 4.80

For the annual figures, the statistics are reported as percentages and computed based on individual bank

data for the each year. Variables are defined in Table 1.a Sources include the Philippine Stock Exchange (1997), individual bank’s Annual Reports, and indi-

vidual bank’s audited financial statements submitted to the SEC and PSE.


between banks. Data for operating performance (AP, NII, and OE) corroborate this

finding highlighting that some commercial banks perform substantially better than

others. These data also highlight responses to the structural changes in the Philippine


banking sector. Interest rate spreads, profits, and non-interest income appear to de-

cline throughout this period. Whether those declines are associated with changes in

foreign presence is investigated further in the next section. Overall our results are

consistent with Claessens et al. (2001), except in the case of interest rate spreads.

Where they find an average spread of 3.5% over the 1988–1995 period, we find anaverage spread of 6.4% over the 1990–1998 period. These differences may be due

to sample construction as referred to previously, or due to our sample excluding

two economically troubled years, 1988–1989.

Ownership data, reported in Table 4, reveals that ECBs are closely controlled.

Comparing ownership data for the pre-liberalization year of 1992 to that of the

post-liberalization year of 1998, we find that average insider ownership declined

from 55.34% to 43.25%. It is interesting to note how insiders are split between direct

insiders and group-affiliated companies, where direct insiders are defined as direc-tors, officers, and related interests (DOSRI). In 1992 the total insider ownership por-

tion of 55.34% is composed of 17.77% by DOSRI and 37.57% by group-affiliated

companies. However, by 1998 DOSRI ownership increased to 23.73%, while

group-affiliated ownership declined to 19.52%. This suggests a movement by group

affiliates away from investing in ECBs and may be a response to banking and finan-

cial market liberalization. Perhaps group-affiliated companies are finding other al-

ternatives for obtaining funds. An alternative explanation is that the ability of

group-affiliated companies to extract wealth through bank ownership has declined.According to the private interest theory developed by Kroszner (1998), well-orga-

nized groups are able to use coercive power over the state to capture rents for these

groups at the expense of other dispersed interests. As the influence of these groups

Table 4

Descriptive statistics on ownership variables for 15 publicly traded domestic ECBsa

Ownership category Ownership from 1992 Ownership from 1998

Average Minimum Maximum Average Minimum Maximum

Foreign ownership 8.69 0.00 39.97 14.81 0.00 40.00

Insiders 55.34 0.00 89.07 43.25 0.00 68.31

DOSRI 17.77 0.00 60.74 23.73 0.00 58.02

Group 37.57 0.00 87.01 19.52 0.00 48.92

Government 2.26 0.00 19.54 5.32 0.00 48.90

Other 33.73 10.90 99.01 36.63 6.63 69.80

Top One 18.17 2.24 39.97 25.12 7.50 48.52

Top Five 50.36 7.93 81.77 61.22 25.93 93.67

Top Twenty 73.94 15.55 99.99 81.29 58.66 99.54

Ownership variables are based on data for year end 1992 and 1998 and descriptive statistics are computed

based on individual bank data for the respective year. Ownership figures are based on the percentage

ownership by category of the top 20 shareholders. Insiders are defined as directors, officers, related

interests, and group-affiliated companies. DOSRI ownership is defined as directors, officers, related in-

terests. One bank is excluded from the original sample due to lack of ownership data for 1992 or any of the

years between 1990 and 1993.a Sources include Philippine Stock Exchange (1997), individual bank’s Annual Reports, and individual

bank’s audited financial statements submitted to the SEC and PSE.


declined after the fall of the Marcos presidency in 1986 and the subsequent economic

reforms, the ability of groups to extract rents may have also declined.

Further evidence of the concentration of commercial bank control is provided

with data for average ownership of the top one, five, and twenty shareholders, also

reported in Table 4. It is interesting to note that these measures of ownership con-centration increased from 1992 to 1998. However, these statistics must be viewed

with caution for the following reasons. First, ownership data for Philippine compa-

nies is difficult to decipher. Some owners mask their identities using front companies

or investors. This was probably more common in the early 1990s as many ex-Marcos

cronies hid assets to avoid government scrutiny. For example, for the Philippine Na-

tional Bank in 1992 the top one, five, and twenty ownership stakes were 2.2%, 7.9%,

and 15.6%, respectively. By 1998, as the government had sequestered shares deemed

to be illegally obtained by ex-President Marcos cronies, the Philippine NationalBank ownership stakes of the top one, five, and twenty categories had risen to

45.6%, 84.1%, and 86.6%, respectively. As evidence, government ownership in-

creased from less than 1.0% in 1992 to 45.9% in 1998. Second, there have been prob-

lems associated with the reporting of ownership data by regulators. Lack of

enforcement powers of regulators and severe under-staffing problems result in signif-

icant inaccuracies in the filing and recording of mandatory ownership data.

5. Analysis of foreign presence

To investigate how a change in foreign ownership affects the operation of domes-

tic banks, we employ a random-effects model to analyze our sample of panel. We

also consider a more generic generalized-method-of-moments (GMM) approach

and a fixed-effects model. Although GMM only requires the specification of certain

moment conditions, its use with small sample sizes as found in our study, may result

in a finite-sample bias (Woolridge, 2001). In addition, whereas the GMM proceduremay be more efficient than a fixed-effects or random-effects model when either het-

eroskedasticity or serial correlation are present, Woolridge (2001) argues that since

basic econometric methods can use robust inference techniques allowing for arbi-

trary heteroskedasticity or serial correlation, the gains from using GMM may be

immaterial. The fixed-effects estimator is robust to the omission of any relevant

time-invariant regressors (Johnston and DiNardo, 1997). However, because of this,

a fixed-effects model cannot include time-invariant explanatory variables, such as

those included in our model. A fixed-effects model removes any effect associated withthese variables, while a random-effects model considers the association between these

time-invariant variables and the dependent variable. 8 Further comparison of these

techniques through a Hausman test indicates that the hypothesis that the individual

8 Zhou (2001) specifically demonstrates the potential problem when using a fixed effects model to

analyze panel data in cases when investigating the relationship between ownership and performance for

US data. He argues that managerial ownership substantially differs across firms, but typically only changes

marginally across time.


effects do not correlate with the other regressors in the random-effects model cannot

be rejected. 9 Therefore, since the fixed-effects estimates are not efficient relative to

the random-effects estimates, we accept the less restrictive random-effects model in

our paper.

In Table 5 we present results of three separate models for each of five dependentvariables, including interest rate spreads (IRS), profits (AP), non-interest income

(NII), operating expenses (OE), and risk (RSK). In the first model we present mea-

sures of foreign presence that capture both the number of new foreign banks entering

the market (FOR#) and the change in the percentage ownership by foreign investors

(FOR%). The second model uses these measures of foreign presence interacted with

a dummy variable that designates whether the ECB is affiliated to a domestic family

group (GRP). The third model again uses these measures of foreign presence but

these are instead interacted with the percentage of group ownership in the ECB(GROUP). We include these interaction terms because a large proportion of produc-

tive assets are controlled by domestic family corporate groups and the degree of

group ownership may affect the relationship between foreign entry and a domestic

bank’s operations (for a discussion see Unite and Sullivan, 2000). For example,

LaPorta et al. (1999) find that in many developing countries the actions of firm man-

agers are oftentimes controlled by the founding families. The control position taken

by these founding families help reduce any severe agency problems that are present

in countries with undeveloped corporate governance systems (Shleifer and Vishny,1997).

We find that foreign bank entry (FOR#) is inversely related to both interest rate

spreads and profits, but only in cases where group-affiliation is important. For exam-

ple, interest rate spreads and profits significantly decline in response to the compet-

itive pressures induced by foreign entry only when those domestic banks are affiliated

to a domestic family business group. Therefore, it is only when the ECB is affiliated

to a domestic group that our findings for the Philippines support those of Terrel

(1986), Bhattacharaya (1993), McFadden (1994), and Claessens et al. (2001). We sur-mise that a decline in group ownership, and therefore the relational banking ties

these groups have with certain affiliated domestic banks, creates an environment

in which these affiliated banks are significantly impacted by competition from the

newly entered foreign banks. Overall, it appears that group-affiliated banks are af-

fected more by foreign entry because group-affiliated banks have relatively higher

pre-liberalization spreads. 10 We take this to be evidence of a decline in the influence

of relationship-based banking.

9 The Hausman test is a chi-squared statistic based on the Wald criterion: W ¼ v2½K� ¼½b� b̂b�0R̂R�1½b� b̂b�, where b is the vector of slope estimates, in the fixed-effects model, b̂b is the vector of

slope estimates in the random-effects model, and R̂R is the difference in the estimated covariance matrices of

the slope estimates with the individual dummy variables of the fixed-effects model and the estimated

covariance matrix in the random-effects model, excluding the constant term.10 We find that for the pre-liberalization period from 1990–1993 the IRS of group-affiliated banks

averaged 9.05%, while for the non-affiliated banks IRS averaged 6.11%. In the post-liberalization period

from 1995–1998, IRS was more similar between these subsamples. For group-affiliated banks IRS

averaged 6.43% and for non-affiliated banks 5.58%.

Table 5

The regressions are estimated using a random-effects model for a sample of 16 Philippine commercial banks for the years 1990–1998

Dependent

variable

Interest rate spreads

(IRS)

Profits

(AP)

Non-interest income

(NII)

Operating expenses

(OE)

Risk

(RSK)

Intercept )2.39�� )1.55 )1.18 10.89� 12.27� 12.10 1.14 1.38 1.27 )4.40� )4.20� )4.46� 4.55�� 5.23� 5.05��

()1.70) ()1.12) ()0.87) (4.96) (5.51) (5.18) (1.11) (1.26) (1.17) ()18.13) ()14.79) ()16.94) (2.45) (2.65) (2.51)

NIA 0.19 0.13 0.13 )0.92� )1.02� )0.98� 0.07 0.06 0.05 )0.02 )0.02 )0.02 )0.34�� )0.38�� )0.39��

(0.31) (0.73) (0.81) ()3.28) ()3.56) ()3.42) (0.48) (0.41) (0.39) ()0.46) ()0.53) ()0.44) ()1.95) ()2.20) ()2.19)EQ 0.23 0.42�� 0.41�� 2.31� 2.64� 2.47� 0.15 0.23 0.18 0.01 0.04 )0.00 ) 0.63�� )0.46 )0.56

(1.26) (2.00) (2.13) (5.58) (5.83) (5.98) (1.12) (1.58) (1.23) (0.19) (0.64) ()0.05) ()1.66) ()1.58) ()1.50)OE 0.34 0.29 0.38�� )1.09 )1.23�� )1.01 0.81� 0.77� 0.81� 0.76 0.68 0.79

(1.41) (1.23) (1.69) ()1.57) ()1.70) ()1.39) (4.14) (4.19) (4.16) (1.49) (1.47) (1.56)

RSZ )0.21�� )0.15 )0.18�� 0.03 0.11 0.07 0.09 0.11 0.12 )0.14� )0.14� ) 0.14� )0.02 0.03 0.02

()2.00) ()1.34) ()1.68) (0.22) (0.84) (0.58) (1.19) (1.40) (1.62) ()4.16) ()3.99) ()3.87) ()0.28) (0.44) (0.34)

GRP 0.63� 0.08 0.22 0.58� )0.64 0.25 )0.08 )0.39 )0.15 0.01 )0.14 0.04 )0.13 )0.91 )0.30(3.34) (0.24) (1.25) (2.79) ()1.30) (1.04) ()0.60) ()1.12) ()1.07) (0.23) ()1.12) (0.56) ()0.64) ()1.07) ()1.35)

OWN )0.79 )0.42 )1.19 )0.31 0.01 )0.51 0.07 0.12 0.24 )0.03 )0.09 0.01 0.02 0.25 0.12

()1.20) ()0.62) ()1.59) ()0.27) (0.01) ()0.36) (0.18) (0.34) (0.55) ()0.12) ()0.30) (0.02) (0.02) (0.31) (0.11)

INFL )0.05 )0.02 )0.02 0.36 0.41�� 0.39 0.16 0.18�� 0.17�� )0.01 0.00 )0.01 )0.06 )0.03 )0.04()0.29) ()0.11) ()0.10) (1.50) (1.71) (1.62) (1.62) (1.77) (1.70) ()0.13) (0.08) ()0.22) ()0.51) ()0.21) ()0.35)

RINT )0.08 )0.06 )0.06 )0.35 )0.32 )0.32 0.42� 0.43� 0.43� )0.05�� )0.04 )0.05�� 0.52� 0.55� 0.54�

()0.45) ()0.35) ()1.23) ()1.38) ()1.29) ()1.30) (4.54) (4.73) (4.69) ()1.77) ()1.63) ()1.88) (4.21) (4.94) (4.39)

GDP )3.01 )2.71 )2.60 18.96� 19.42� 19.37� 2.69�� 2.77�� 2.73�� )1.19�� )1.14�� )1.22�� )8.10� )7.89� )7.93��

()1.36) ()1.27) ()1.23) (5.01) (5.14) (5.19) (1.88) (1.92) (1.94) ()2.47) ()2.36) ()2.50) ()2.73) ()2.66) ()2.77)RR )0.09 0.01 )0.01 5.81� 6.01� 5.88�

()0.21) (0.03) ()0.02) (4.90) (4.99) (4.89)

FOR# )0.09 0.11 0.08 0.19 0.57� 0.33 )0.11 )0.03 )0.09 )0.19� )0.17� )0.21� 1.08� 1.31� 1.14�

()0.78) (0.75) (0.60) (0.99) (2.59) (1.61) ()1.37) ()0.24) ()0.99) ()6.83) ()4.50) ()6.64) (3.34) (2.82) (3.43)

FOR% 0.79 1.51�� 1.09 0.95 1.35 1.16 )1.08� )1.03�� )0.89�� 1.49� 1.21� 1.45� )0.82 )0.40 )0.59(1.25) (1.93) (1.62) (0.88) (1.22) (0.98) ()3.21) ()2.15) ()2.16) (5.21) (2.89) (4.55) ()0.96) ()0.42) ()0.68)

FOR#� )0.37�� )0.71� )0.17 )0.06 )0.48GRP ()2.33) ()3.02) ()1.19) ()1.14) ()1.27)FOR%� )1.35 )0.58 0.01 0.49 )0.70GRP ()1.39) ()0.51) (0.01) (1.08) ()0.88)FOR#� )1.05� )0.84�� )0.17 0.08 )0.44��

A.A.Unite,

M.J.Sulliva

n/JournalofBanking&

Finance

27(2003)2323–2345

2339

Table 5 (continued)

Dependent

variable

Interest rate spreads

(IRS)

Profits

(AP)

Non-interest income

(NII)

Operating expenses

(OE)

Risk

(RSK)

GROUP ()3.22) ()2.03) ()0.67) (0.76) ()1.71)FOR%� )1.50 )1.86 )1.63 0.13 )2.21GROUP ()0.53) ()0.56) ()0.91) (0.12) ()0.89)

R2 (%) 18.14 21.60 26.42 57.98 59.74 58.90 32.37 33.05 32.66 49.93 50.91 50.12 21.91 22.99 22.32

Parameter estimates of separate regressions relating various dependent variables, (1) bank interest rate spreads, (2) profits, (3) non-interest income, (4)

operating expenses, or (5) risk, to a set of independent variables. Variables are defined in Table 1. We report t-statistics in parentheses based on White’s (1980)

heteroskedasticity-consistent variances and standard errors.* Significant at the 0.01 level.** Significant at the 0.05 level.*** Significant at the 0.10 level.

2340

A.A.Unite,

M.J.Sulliva

n/JournalofBanking&

Finance

27(2003)2323–2345


In addition, we find that as the relative size of the bank (RSZ) increases, the greater

will be the associated decline in interest rate spreads and profits. Because we also find

evidence that the smaller banks are subject to greater decreases in interest rate

spreads, we conclude that the smaller ECBs respond to foreign competition by in-

creasing their size more quickly than larger ECBs. 11 We surmise that group-affili-ated banks and smaller ECBs are often better politically connected with more

established relationships, and therefore, liberalization which deregulated foreign

bank entry had a more profound effect on the earnings and profits of these politically

connected banks. It may be that these politically connected banks lost political influ-

ence during this period. These findings support the contention of Rajan and Zingales

(2000) that politically powerful groups will not give up economic power easily. In the

Philippines, this banking liberalization took place in a time period following a dra-

matic change in government when the ex-cronies of the past President Marcos hadlost much of their political influence. Politically this type of deregulation was not

possible prior to the pro-market administration of President Ramos that started in

1992 and extended through 1998 (Unite and Sullivan, 2000).

As opposed to group-affiliated banks, the relatively faster growing ECBs appear to

be able to become more efficient, as indicated by the inverse relationship between op-

erating expenses and relative size. We conclude that the intent of the banking lib-

eralization, to make domestic banks more competitive and efficient, has worked

effectively in the case of this set of fast growing ECBs. Group-affiliated banks, al-though adversely affected in terms of revenues and profits, are not found to be be-

coming more efficient. Perhaps these group-affiliated banks provide benefits to

other group corporations that preclude them from markedly reducing operating

expenses.

We also find that the entry of foreign banks leads to a decline in operating ex-

penses and an increase in bank risk. The decline in operating expenses is consistent

with findings of Claessens et al. (2001). This finding suggests that banking liberaliza-

tion allowing foreign entry has resulted in greater efficiency. The increase in loan lossprovisions associated with foreign bank entry supports the contention of Claessens

et al. (2001) that domestic banks are forced to take on less creditworthy customers

due to the increased competition brought by the entry of foreign banks.

Liberalization pertaining to foreign ownership of domestic banks does not appear

to have as an important influence. We find only that increases in the percentage own-

ership by foreign investors in domestic banks (FOR%) cause an increase in operating

expenses and a decrease in non-interest income. Whereas, operating expenses are

shown to decline with foreign bank entry as expected, operating expenses increaseas the percentage of ownership in domestic banks by foreigners increases. This find-

ing may be comparable to Barajas et al. (1999b), who find that there is a component

of liberalization unrelated to entry that causes the administrative costs of domestic

11 We find that for the pre-liberalization period the IRS of the three smallest ECBs averaged 12.29%,

while the IRS of the three largest ECBs averaged 6.43%. In the post-liberalization period the IRS between

these subsamples of ECBs became more similar. For the smaller ECBs IRS averaged 6.16%, while for the

larger ECBs IRS averaged 5.33%.


banks to rise. Perhaps this is related to an increase in intermediation costs resulting

from stricter provisioning and reporting requirements that accompanied liberaliza-

tion. There may also be an increase in costs as banks ready themselves for competi-

tion, specifically costs related to activities, such as, the hiring of higher-skilled

employees, training current employees, and the acquisition of upgrading of equip-ment. This suggests that increases in foreign ownership provide managers the impe-

tus to modernize their operations. The decline in non-interest income associated with

greater foreign ownership supports a view that with greater levels of foreign moni-

toring domestic banks reduce their dependence on non-banking areas of business.

Although we do not find that foreign ownership levels are significantly associated

with spreads or profits, there is assumably a corresponding increase in revenues from

traditional banking sources associated with foreign ownership that makes up for this

decline in non-interest income and increase in operating expenses.Besides effects related to foreign presence, the bank-level and general economic

factors we employ as control variables are found significant in many cases. Profit

is found to be negatively associated with non-interest earning assets (NIA), the level

of funding (FND), and operating expenses (OE), and positively associated with eq-

uity levels (EQ). The negative relationship between non-interest earning assets and

profits suggests that banks that focus on non-interest earning assets suffer relatively

greater profit erosion. This supports a view that banks are more profitable when they

focus on traditional banking services. The direct relationship between profits and eq-uity levels corresponds to findings for US banks. Berger (1995) discusses how profits

should be positively related to equity levels since this will encourage more prudent

lending, and therefore, better performance. The negative relationship between oper-

ating expenses and profits correspond to results of Denizer (1999) and Claessens et al.

(2001). Our results imply that Philippine banks are unable to pass higher operating

expenses on to customers.

With non-interest income (NII) as our dependent variable, we find evidence of a

positive relationship with operating expenses. This supports the view of Claessenset al. (2001), that banks incur greater operating expenses in order to generate more in-

come from alternative sources. Bank risk (RSK) is shown to be significantly affected

by two bank-level variables, non-interest earning assets and equity levels. The inverse

relationship between risk and non-interest earning assets may be a consequence of

banks diversifying their cash flows streams by relying on sources of business rather

than only loans. The inverse relationship with equity levels points to a general in-

crease in risk in the banking sector, since banks are relying less on equity sources

for funding at the same time bank asset quality appears to be deteriorating.Of the general economic variables, the level of GDP and reserve requirements are

positively related to profits, but not interest rate spreads. The effect of GDP growth

makes sense from the aspect that when the spread between interest revenues and ex-

penses is constant, profits will increase as the amount of business increases with eco-

nomic activity. These findings correspond with findings of Demirg€uuc�-Kunt and

Detragiache (1998). The direct relationship between profits and reserve requirements

is opposite than expected since higher reserve requirements reduce the level of funds

available to earn interest. Perhaps this is related more to the timing of changes in re-


serve requirement by the Bangko Sentral ng Pilipinas, where the Bangko Sentral in-

creases reserve requirements when bank profits are increasing and cuts reserve re-

quirements when bank profits are declining.

Our finding that non-interest income is positively related to the level of real inter-

est rates is contrary to that of Claessens et al. (2001). Our results suggest that Phil-ippine banks turn to non-traditional sources of revenues in periods when real interest

rates are high. Operating expenses are inversely related to GDP, corresponding to

the findings of Claessens et al. (2001), but opposite of that found by Denizer

(1999). This indicates that Philippine bankers do not react quickly to economic de-

clines by cutting operating expenses. The level of loan loss reserves is found to be

positively related to the level of real interest rates (similar to Barajas et al., 1999b)

and negatively related to GDP (similar to Claessens et al., 2001, but opposite of find-

ings of Barajas et al., 1999b). Loan quality of Philippine banks appears to strengthenas real interest rates rise, but deteriorates as expected when the economy suffers.

6. Conclusions

Recent reforms undertaken in the Philippines that liberalized restrictions on the

involvement of foreign interests in the domestic banking market appear to have re-

sulted in favorable consequences. Overall, we find evidence that interest rate spreadsnarrow and operating expenses decline with greater foreign bank entry. This sup-

ports the hypotheses that foreign competition reduces interest rate spreads as both

domestic and foreign banks vie for the same business, and that foreign competition

forces domestic banks to be more efficient. However, the narrowing of interest rate

spreads is concentrated in banks with higher levels of group-affiliate ownership,

while gains in efficiency are lower for domestic banks subject to rising foreign own-

ership of their shares. We conclude that the intent of the banking liberalization, to

make domestic banks more competitive and efficient, has worked effectively in thecase of larger Philippine banks. Group-affiliated banks, although adversely affected

in terms of revenues and profits, are not found to be gaining in efficiency. Perhaps

these group-affiliated banks provide benefits to other group corporations that pre-

clude them from markedly reducing operating expenses.

We also find that the entry of foreign banks is directly related to increases in risk.

The increase in loan loss provisions associated with foreign bank entry supports the

contention of Claessens et al. (2001) that domestic banks are forced to take on less

creditworthy customers due to the increased competition brought by the entry of for-eign banks. The increase in the percentage ownership by foreign investors in domestic

banks is shown to result in an increase in operating expenses and a decrease in non-

interest income. This relationship may capture an increase in intermediation costs as-

suming increases in foreign ownership are related to providing managers the impetus

to modernize their operations. The decline in non-interest income associated with

greater foreign ownership supports a view that with greater levels of foreign monitor-

ing domestic banks reduce their dependence on non-banking areas of business.

Overall, we conclude that foreign competition induces domestic banks to be moreefficient. As a result of these competitive pressures and increased monitoring, we


expect a general weakening of relationship-style banking. Our findings support this

view, as we find that banks that are likely to be more politically connected suffer

greater declines in spreads and profits, and are able to reduce operating expenses

to a greater extent. Therefore, overall we expect banks to become more independent

and to lose much of their political influence. This should lead to better lending prac-tices, where the allocation of funds depends more on merit. As a consequence, we

believe liberalization of foreign presence will have positive effects on economic

growth and will enhance the ability of the economy to overcome negative external

shocks.

Acknowledgements

We wish to acknowledge Rhod Santos of Wellex Global Equities, Inc., Soccy Cle-

mente of the Research Department of the Philippine Stock Exchange, and Pinky Su-

petran of De La Salle University––Manila for their assistance in the collection of

sample data. We also thank Mike Alba, Myrna Austria, Jeffrey Brookman, Sae-

young Chang, Seungmook Choi, Pons Intal, Jr., Melvin Jameson, Mario Lamberte,Stephen Miller, Melanie Milo, Alan Schlottman, Bradley Wimmer, and two anony-

mous referees for helpful comments.

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